Who needs stock exchanges?

Date 14/07/2006

Clem Chambers
CEO, ADVFN

Past performance is no guarantee of future returns, or so the
theory goes. Yet how many investors and traders really believe
that? It is a brave trader that doesn't fall back
on stock charts to try and predict the future. While the theory
says that the market is a random walk, how many fund managers would
keep their jobs if they said they never bothered to look at stock
charts because it is theoretically pointless?

So it is perhaps not too ironic to look to the past history of
stock exchanges to glimpse the future of the world's bourses.
While history might not be a good guide to the future of a stock
time series, it illuminates the trends so elusive in stocks
themselves and throws light on why exchanges will continue to be
pivotal to economies and the peoples of the world.

The first stock exchange was founded in Amsterdam by the world's
first multinational; the Dutch East India Company. As such, the
Dutch East India Company was the first company to issue stocks and
it did so for the very same reason companies IPO today; to raise
money to build their business. The Dutch had reached a stage where
they needed to reorganise their economy and they did so with a
revolutionary idea of public issuance.

The Amsterdam bourse was founded in September 1602 within six
months of the company's formation
and was an integral component to its success; it grew to an
organisation of 50,000 civilian employees, with a private army of
40 warships, 20,000 sailors and 10,000 solders and a mind blowing
dividend flow. The whole of Holland was revitalised.

With a market for its stocks and bonds, the Dutch East India
Company became probably the most powerful business in the history
of the world. It became, to all intents and purposes, a state
within a state; just the kind of company fit for a James Bond plot.

It seems highly unlikely that companies will ever again lay siege
to markets with troops and gunboats. The first public company was
without doubt the mightiest there has ever been.

Yet the key to the success of the Dutch East India Company was that
its ownership had been opened up to the public. This enabled the
vast sum of 6.5m guilders to be raised. The exchange also allowed
the company to issue bonds to finance its short term needs. In this
way the first stock exchange was a crucible of modern capitalism.
The history of the Dutch East India Company is also a kind of
template of what was to happen to companies on stock markets over
the years to come.

The company's IPO saw a
'pop' of
15% to its issue price, the first opportunity for investors to stag
an IPO in history. It is intriguing to imagine that somewhere in
the record there may well be the name of the first stock flipper in
history, though it is unlikely that many of the initial
shareholders 'stagged' the
issue, as the actual concept of stock market trading wasn't yet
invented; buying and selling was a manual and laborious affair.

Long-term holders were on to a good investment too, and twenty
years later the share price had risen 300%. This might not seem
like a particularly stellar return, but during the period the
average dividend from the company was a fat 18%. Clearly investors
at the time were not so interested in capital

appreciation and looked to income for their returns. Life was short
in the 17th century, so investors looked for the sort of returns
that today could never be delivered. While P/E ratios weren't yet
invented, the P/E of the Dutch East India Company was very low and,
though the actual accounts of the company were not transparent, the
P/E of the company must have been nearly one when, four years after
its foundation, the company paid a record dividend of 75%.

However, the executive board of the company seemed to have been
under just as much pressure to make its numbers as any modern group
of execs and the company resorted in later years to all kinds of
financial engineering to keep up its notional shareholder returns.
Cash dividends were increasingly replaced by bonds, and even spices
like pepper were used as payment.

Soon shareholders were known as 'pepper
sacks', undoubtedly for their ownership of hard-to-dispose-of aromatic
payments in lieu of cash.

Then, of course, along came tulip mania - the first
of many speculative market bubbles to come. This period, which
witnessed tulip bulbs explode in value under the influence of what
amounted to options trading, saw the company's stock
rise to 1200% of its original issue price. By the late 18th
century, after nearly 200 years of operation, the company began to
fail and the share price crashed. With 110m guilders of debt, the
Dutch East India Company imploded in a way Enron shareholders would
recognise. The Dutch state stepped in and took on its debts. While
the story of this individual company was over, the history of stock
markets was only just beginning.

Meanwhile, in 1698, a John Castaing began to issue a list of stock
and commodity prices in Jonathan's
Coffee-house. Trading in London had already begun and soon dealers
where making such an uproar that they had to be expelled from the
Royal Exchange, the traditional centre for commerce in London. The
Royal Exchange was a centre for dealing in physical objects, the
goods that came and went through the port of London, but stocks
were a natural extension of the contracts and bills that passed
during transactions.

However, stocks represented a new dynamic. They were a derivative
of a new powerful kind and as such it was only to be expected that
they would create an explosive atmosphere. New financial
instruments are powerful and dangerous things. Most of the most
famous and costly booms and busts have been caused by a new
instrument being unleashed on a greedy and ignorant audience. It is
only after the market has learned an expensive lesson that the
long-term application of the instrument turns to the greater good.
Somewhere in every bust there lurks an expensive learning curve
that, given time, pays handsome returns.

Having been exiled from the Royal Exchange, the stock traders took
to the streets and coffee houses. Ironically, in the modern era,
the Royal Exchange is now just a collection of trendy boutiques and
an expensive wine bar for the once rebuffed stock dealers. This
would be a sweet victory was it not for the fact that the market
has no long-term memory. This free-form stock

market survived until 1773, nigh on a century, and encompassed the
first iteration of the industrial revolution and spanned the
UK's first
financial boom and bust, 'the South
Sea Bubble'.

It wasn't until a
further 50 years had passed that the first London Stock Exchange
was formed and even then it was initially known as 'the new
Jonathan's';
hardly the branding for a national institution. Unsurprisingly it
still retained a coffee shop on the floors above the trading area.
The re-branded Stock Exchange, with or without the coffee vending,
continued to act as a crucible for the British industrial
revolution, and all the while the notion of equity was spilling
over Europe and into the US.

While fortunes are made and lost, there is nothing respectable or
institution-like in the nature of the London Stock Exchange and it
is not until 1801 that there is any regulation or formal membership
to be seen or had.

While powering the biggest step change in history, many still
considered buying and selling shares immoral and downright evil,
and as cycles of boom and bust and speculation roiled the stock
exchanges of the world there was plenty of evidence that this dim
view of stock markets in general must be true. Yet without stock
markets and 'Railway
Mania', railways
would never have been built and while fortunes were being
destroyed, new ones were being made.

At about the same moment as John Castaing was publishing his list
of financial instruments, stock brokers were meeting under a tree
on Wall Street to trade stocks.

Wall Street was a crude defensive wall set up by the Dutch and, for
whatever reason, became the point in New York where speculators got
together to trade. In 1792 twenty-four stock brokers signed an
agreement which constituted the New York Stock & Exchange Board
- the
original entity that was eventually to become the NYSE.

The Buttonwood agreement, as it was known, can be seen as not only
the beginning of the New York Stock Exchange but also as an
inevitable event in the development of the US and its rise from
continental frontier to superpower. It is hardly surprising that
Wall Street was also the genesis of another US icon - the
skyscraper - as the
concentration of power and money created by financial trading
forced buildings that once hugged the ground to be pushed ever
higher into the skies.

In the modern era stock trading has lost much of its louche
reputation. It is no longer a dangerous, sinful and reprehensible
activity guaranteed to ruin a gentleman, but is instead a
transparent-regulated industry of the highest propriety. However,
for much of its history the trading activity on stock exchanges was
as much a conduit for 'animal
spirits' as the
race track, while today the very basis of a stock market's
purpose is the balancing and exploitation of risk.

These animal spirits - as
Maynard Keynes termed them - are
perfectly illustrated by the battle of Throgmorton Street in London
at the turn of the 20th century. In a period famous for its
law-abiding rectitude, for its gentlemen in top hats espousing that
their word was their bond, and in the time of Queen Victoria when
morals and decency were most valued, brokers, who were busily
trading gold shares in the street after hours, chose to fight
police three days running, rather than be interrupted in their
trading. A public brawl one evening might be easily explained as a
one-off, but three days of commotion is akin to the sort of
uprising generally associated with social revolt. Such is the power
of equity.

Many industries have a tendency to concentrate. While some remain
atomised, most human activity benefits from scale. In the modern
era it is part of government policy to resist this natural gravity,
to stop the consolidation of economic activity before it becomes an
anti-competitive monopoly. Monopolies are generally considered bad
because concentration leads to pricing power and this power works
against the benefit of the consumer. In an ideal world the
economies of scale delivered by a monopoly would be passed straight
to the customer, but in practice it is the tendency of competing
companies to operate at near breakeven that delivers the customer
benefits that a monopoly can afford to shy away from.

Stock exchanges are natural monopolies because their scale is a
direct benefit to their customers. Liquidity is the advantage that
traders value most and trading naturally flows to the largest
player with the most liquidity. This is a self re-enforcing
process. Liquidity is the fuel of any market and the lower the cost
of trading the greater the liquidity. The greater the liquidity the
lower the costs can be, and more liquidity will be created if the
costs are optimal for the customer and the exchange. This loop is
the factor that protects the customer from the monopoly, and in
practice this appears to be what happens.

In the modern world liquidity is as vital as oxygen. When the
London brokers were expelled from the Royal Exchange or arrested in
Throgmorton Street for rioting, it was the drive of liquidity that
lay behind the outrageous behaviour. Traders, brokers and exchanges
themselves live or die by the availability of liquidity, because in
the end the market is its liquidity and for once scale is on the
side of 'the
angels'. The answer
to why the world needs stock markets is really a question of why
the world needs liquidity. The history of human development is the
history of money and the history of money is the history of the
development of liquidity.

The invention of money, the first and still greatest derivative,
was as great an invention as fire or the wheel. A liquid proxy of
value opened the world for human expansion; with it trade and
cities grew. It has always been thought, since their invention,
that the growing size of cities could not be supportable. From
Athens to modern mega-cities, the question has been how can these
sterile places be fed and provisioned. Surely cities would become
too big to be supported by their hinterlands and at some point
collapse. But as they grew, money and markets enabled them to be
sustained. Money meant there would be food enough to feed the
concentrated human activity. Be it the Agora in ancient times or
the financial exchanges of today, markets remain the pivots of our
economies.

Today the world will trade its wealth through derivatives; so that
while someone somewhere will continue to swap a chicken for a sack
of corn, 99.99% of the world will depend on the trading of one kind
of derivative or other through an exchange for our very existence.
Corporations will continue to be, as the East India Company was in
the 17th century, the agents of economics and progress. As such,
the stock exchange is critical to the economies of the world.

The market, as no one likes to believe, is always right and while
it is easy to laugh at stock market booms and busts, they most
often signal the birth of a new chapter in our economic history. It
is easy, for example, to look back at the dotcom boom and see only
the rise and fall of ridiculously overvalued companies with blue
sky ideas and no business plan to sustain

them. However, today the survivors of that pure equity-fueled boom
are reshaping the economic and social landscape of the world that
we live in. Without stock markets there would be no eBay or Amazon
or Vodafone, no huge drug companies, no Google. Where would GE be
without its publicly traded equity? Would fading giants like GM
even still be making cars without the liquidity for its equity?

In short, the modern world relies on market liquidity in the same
way that Rome relied on water carried to it by its aqueducts. It is
interesting to note that Rome's great
history was brought to a rapid and desolate end when the Ostrogoths
simply destroyed the aqueducts and in one blow made the city
uninhabitable for the best part of 1000 years. In the modern world
market liquidity is no less vital and it is no surprise that those
who would hurt our way of life, first strike at our markets. Market
liquidity provides the efficiency necessary to run the modern
world, and stock markets provide the capital at a price necessary
to power the world's growing
economies.

The human world is no longer a natural and organic place. It simply
cannot support itself without its vast mechanical infrastructure
that acts on many levels as the lever to provide the more-for-less
that keeps six billion people alive. So with economic growth it is
no surprise that stock exchanges are more and more liquid and that
more and more money is pouring around the bourses of the world.
Stock market liquidity is as necessary for our daily well-being as
oil pumped from the ground. Without the world's stock
markets there would be less and it would cost more: be that drugs,
oil, food or a telephone call. Money still makes the world go
round, and it does so to a significant extent by lapping the
circuit of the world's stock
markets.

This process can only grow. In a world that is seeing perhaps three
billion people climbing from poverty to what we in the western
world recognise as a reasonable standard of living, the pace of
economic activity can only accelerate. In the same way as we can
look back at the 20th century and see the economic activities in
our countries as almost unrecognisably small, so in a decade or two
we will look back at current levels of activity and marvel at its
limitations. Soon headlines will only mention trillions where
before news was measured in billions, and soon enough we will start
seeing in the press a quadrillion as a unit of money and we will
have forgotten how, as recently as the 80s, millions were still
considered a significant order of magnitude. This growth will see
stock markets trading at levels that we can only imagine today.

While a Nasdaq TotalView screen looking onto the frenetic trading
of Google gives us an idea of what the future holds, it is hard to
truly understand the step change this will bring about. Trading is
still an activity that can be judged by the eye, it is still only
exceptional companies or exceptional times when trading activities
turn into sub-second price moves; or moments of liquidity faster
than the human eye can appreciate. But even now, trading can turn
from trade-by-trade activity into a fluid stochastic phase where,
like electrons, the price takes on a velocity at which only a trade
print can determine to the human observer what price was dealt.
Inevitably, markets will trade faster than the human eye at all
times and transactions will be crossed at para-human speeds, and
this will drive yet more progress.

People will still come to the bourses with their animal spirit and
back their hunches with their hard-earned capital. There will be
booms and busts and scandals. The regulators will regulate, the
lawyers will sue, the speculators will trade and promoters will
promote. Stocks will go up and down, fortunes will be made and lost
and they will declare that this time everything will be different
but it won't be. Who
will need stock markets then? Everyone; because without the
markets, as surely as in Rome after the barbarians felled the
aqueducts, we would all starve.

Clem Chambers is CEO of stocks and investment website ADVFN
(www.advfn.com). Clem wrote a stock column for Wired from 2000 to
2001 and is currently a columnist for many publications,
including UK national newspapers The Business and The
Scotsman. He is also a regular contributor for a number of UK and US financial publications, and makes frequent
appearances on the BBC, CNBC Europe and SKY.